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I recently wrote with a perspective on how much retirees can possibly distribute from their portfolios each year without depleting their retirement nest eggs. (What Portfolio Withdrawl Rate Can You Live With?) . Our research, which spanned the five most recent 35-year periods (with the final one ending December 31, 2011), concluded that investors with diversified, balanced portfolios were in each case able to withdraw 4% of the portfolio each year without exhausting their capital over those long time horizons. In each scenario, we withdrew a fixed percentage (4%-8%) of the portfolio’s initial value annually, with the amount of monthly withdrawals adjusted annually for actual inflation rates in the prior year.

But there’s another withdrawal method that‘s worth discussing: rather than basing withdrawals on the starting portfolio value (adjusted for inflation), we’ll examine what happens when an investor takes portfolio distributions based on the actual performance of the portfolio over time.

To evaluate this, we model withdrawals based on the performance of our 50/40/10 portfolio used in the earlier study, where 50% of the portfolio is invested in domestic stocks (as represented by the S&P 500 Index), 40% in intermediate-term US bonds and 10% in cash reserves. The withdrawals are determined at the start of every month by observing the amount the investor has in his portfolio. For an annual withdrawal rate of 4%, we withdraw 4/12 = 0.33% of the portfolio value every month.

This method has the advantage of examining portfolio withdrawals in retirement in the context of actual market performance and investor behavior. For example, let’s assume that investors withdraw a fixed percentage of a portfolio, say 4%, regardless of market performance. In practice this means that retirees will withdraw (and spend) more dollars in years with strong portfolio performance, while cutting dollar withdrawals and curtailing spending when markets and portfolio balances decline (e.g., 2008). In other words, we make a reasonable assumption that people modify their lifestyles and spending proportionally to the asset levels in their retirement accounts.

In our earlier analysis, where withdrawals were a fixed percentage of the inflation-adjusted initial portfolio value, the 1973-2007 period was one in which only the 4% withdrawal rate (and not the 5%-8% rates) avoided depletion of capital during a 35-year period. Let’s now evaluate how a 4% withdrawal rate under our revised method would have worked during that same time period with the same 50/40/10 portfolio. As shown in Exhibit 1, the actual dollar amounts of 4% withdrawals spiked during the bull market of the late 1990s but then plunged after the stock market bubble burst in 2000. By contrast, withdrawals under the inflation-adjusted method rise in a much more regular, step-like fashion. Exhibit 2 illustrates that at the end of the 35-year period, the basic 4% withdrawal portfolio has 2.25 times more capital remaining than the portfolio in which a fixed and inflexible, inflation-adjusted amount was withdrawn during the same time frame.

We also conducted the same tests at a 5% withdrawal rate using both methods. As demonstrated in Exhibit 3, the constant inflation- adjusted withdrawal amount is higher in most months when compared to simply distributing 5% of portfolio value.

As in our first study, a 5% withdrawal rate is unsustainable over the time period, but note in Exhibit 4 that the portfolio not only survives but actually increases in value when the investor tailors 5% withdrawals to actual portfolio values. A portfolio will survive over a long time span when withdrawals are a percentage of portfolio value, though at a high withdrawal rate funds may be insufficient to support an investor’s lifestyle.

Conclusion

Retirees may choose to set their withdrawal rate as a fixed percentage of starting portfolio value (adjusted for inflation) or to take a percentage of actual portfolio value. A prudent approach for investors who choose the latter method would be to reduce dollar withdrawals during periods of poor market performance and avoid over-spending when portfolio values are up significantly.

IMPORTANT DISCLOSURE INFORMATION

Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Gerstein Fisher), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. A copy of the Gerstein Fisher’s current written disclosure statement discussing our advisory services and fees is available for review upon request.